Chapter 1 Introduction to Finance

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Road Map

Part A Introduction to ﬁnance.

• Financial decisions and ﬁnancial markets. • Present value.

Part B Valuation of assets, given discount rates.

Part C Determination of risk-adjusted discount rates.

Part D Introduction to derivatives.

Main Issues

• What Is Finance

• Valuation of Assets – Opportunity Cost of Capital – Present Value (PV)

• Role of Financial Markets

• Objectives of Financial Manager Chapter 1 Introduction to Finance 1-1 1 What is Finance?

• Finance is about the bottom line of business activities.

• Every business is a process of acquiring and disposing assets:

– Real assets (tangible and intangible). – Financial assets.

• Two objectives of business:

– Grow wealth. – Use wealth (assets) to best meet economic needs.

• Financially, a business decision reduces to valuation of assets.

• Valuation is the central issue of ﬁnance.

Fall 2006 c J. Wang 15.401 Lecture Notes 1-2 Introduction to Finance Chapter 1

Questions we would like to answer in this course:

1. How ﬁnancial markets determine asset prices?

2. How corporations make ﬁnancial decisions?

• Investments: - What projects to invest in?

• Financing: - How to ﬁnance a project?

• Payout: - What to pay back to shareholders?

• Risk management: - What risk to take or to avoid and how?

15.401 Lecture Notes c J. Wang Fall 2006 Chapter 1 Introduction to Finance 1-3

1.1 Cash Flow of A Firm

(2) (1)

Firm’s Financial Investors (4) Operations Manager – individuals – institutions ... - - (3) (5)

(1) Cash raised from investors by selling ﬁnancial assets.

(2) Cash invested in real assets (tangible and intangible).

(3) Cash generated by operations.

(4) Cash reinvested.

(5) Cash returned to investors. – mandatory (e.g. loan payments) – discretionary (e.g. dividends)

Fall 2006 c J. Wang 15.401 Lecture Notes 1-4 Introduction to Finance Chapter 1

1.2 Task of Financial Manager

(2) (1)

Firm’s Financial Investors (4) Operations Manager – individuals – institutions ... - - (3) (5)

Action: Manage cash ﬂow (1), (2), (4), (5).

• Investment: (2) ⇒ (3).

• Financing and payout: (1), (4), (5).

• Risk management: (1) and (5).

Objective: Create value for shareholders.

15.401 Lecture Notes c J. Wang Fall 2006 Chapter 1 Introduction to Finance 1-5

To make sound ﬁnancial decisions, we need to know how to value assets.

• Investment decision: How real assets are valued.

• Financing and payout: How corporate securities are valued.

• Risk management: How ﬁnancial contracts are valued.

Fall 2006 c J. Wang 15.401 Lecture Notes 1-6 Introduction to Finance Chapter 1 2 Valuation of Assets

Each asset is deﬁned by its cash ﬂow (CF).

Time: 012···

Cash out: CF 0 ·····

Cash in: · CF 1 CF 2 ···

Net cash ﬂow: (−)CF 0 CF 1 CF 2 ···

Value of an asset = Value of its cash ﬂow:

2.1 Important Characteristics of A Cash Flow

1. Time: time value of money.

Example. $1,000 today vs. $1,000 next year.

2. Risk: risk premium.

Example. $1,000 for sure vs. $0 and $2,000 with equal odds.

Time and uncertainty are two key elements in ﬁnance.

15.401 Lecture Notes c J. Wang Fall 2006 Chapter 1 Introduction to Finance 1-7

2.2 Approaches to Asset Valuation

1. Valuation by “matching”:

(a) The ﬁnancial market contains a rich set of traded assets.

(b) Given a CF, ﬁnd a traded asset with equivalent CF:

• Timing.

• Risk.

Assets with same payoﬀs have same prices.

2. Valuation by analysis of demand/supply (equilibrium).

Fall 2006 c J. Wang 15.401 Lecture Notes 1-8 Introduction to Finance Chapter 1

2.3 Opportunity Cost of Capital

An investment is an acquisition of an asset:

• Pay cash today.

• Receive cash ﬂow in the future.

Capital investment trade-oﬀ:

1. A ﬁrm can always give cash back to shareholders.

2. A shareholder can invest in ﬁnancial markets.

' $ Investment opportunities Project - Share- - CASH holder available in ﬁnancial & % markets

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Definition: Opportunity cost of capital is the expected rate of return offered by equivalent investments in financial markets.

15.401 Lecture Notes c J. Wang Fall 2006 Chapter 1 Introduction to Finance 1-9

2.4 Present Value

Example 1. How much is a sure cash ﬂow of $1,100 in one year worth now?

Safe assets in ﬁnancial markets oﬀer 5% annual return.

A potential buyer of the sure CF also expects 5% return. Let the price be X.Then

X(1 + 0.05) = 1, 100.

Thus, 1, 100 X = =$1, 048 1.05 which is the CF’s present value, i.e., its current market value.

Observation: Present value must properly adjust for time.

Fall 2006 c J. Wang 15.401 Lecture Notes 1-10 Introduction to Finance Chapter 1

Example 2. How much is a risky cash ﬂow in one year with a forecasted value of $1,100 worth now?

Assets of similar risk in ﬁnancial markets oﬀer 20% return.

A potential buyer of the risky CF also expects 20% return. Let the price be X.Then

X(1 + 0.20) = 1, 100.

Thus, the present value of the risky CF is 1, 100 X = = $917. 1.20

Observation: Present value must properly adjust for risk.

The diﬀerence in (expected) return between risky and safe assets is the risk premium.

The present value of an CF equals its expected value discounted at the opportunity cost of captial.

15.401 Lecture Notes c J. Wang Fall 2006 Chapter 1 Introduction to Finance 1-11 3 Role of Financial Markets

3.1 Financial Markets at Center of Universe

Individuals & %

' $

Financial Markets & Financial Intermediaries

& %

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Firms

Fall 2006 c J. Wang 15.401 Lecture Notes 1-12 Introduction to Finance Chapter 1

• Financial Markets - where ﬁnancial assets are traded

- Money markets: Short-term debt securities – Short-term government debt (T-bills, ...) – Short-term bank and corporate debt (CDs, CPs, ...)

- Capital markets: Long-term securities – Government debt (T-notes and T-bonds) – Corporate debt – Stocks, ...

- Derivatives: Securities with payoﬀs tied to other prices – Forwards and futures – Options, ...

• Financial Intermediaries - Own mostly ﬁnancial assets - Banks - Insurance companies - S&Ls - Mutual funds, ...

• Corporations - Own mostly real assets

• Individuals - Own both real and ﬁnancial assets.

15.401 Lecture Notes c J. Wang Fall 2006 Chapter 1 Introduction to Finance 1-13

3.2 Functions of Financial Markets

1. Allocating resources:

• Across time. Example – Borrow money to buy a home.

• Across diﬀerent states of economy. Example – Invest in stocks/bonds.

2. Communicating information. • Market prices reﬂect available information.

Assumptions on ﬁnancial markets – A “perfect” ﬁnancial market:

- A rich set of securities traded.

- Free access.

- Competitive trading process.

- No frictions.

Fall 2006 c J. Wang 15.401 Lecture Notes 1-14 Introduction to Finance Chapter 1 4 Objectives of Financial Manager

1. Factors affecting a firm’s financial objective: • Timing? • Risk? • Accounting? • “Long-run” value? • ...

2. Maximizing current market value is the only plausible ﬁnancial objective.

3. Current market value incorporates present value of all current and future cash ﬂows, adjusted for timing and risk.

4. Market value rule is independent of shareholders’ diﬀerences.

Manager objective: Maximize current market value of the ﬁrm.

15.401 Lecture Notes c J. Wang Fall 2006 Chapter 1 Introduction to Finance 1-15

Example. 50MD is a small company traded on NASDAQ. Three members of the founding family, Granny, Father and Son, jointly own a controlling interest. You, as the CEO of 50MD, are evaluating two new business plans, A and B, and conclude:

• Both have positive net PVs (NPV) but only one can be taken.

• A pays oﬀ in three years and B starts to payoﬀ after ten years.

• B is much riskier than A.

• B has a higher NPV.

You recommend B over A, but all three shareholders object:

1. Granny: “Kid, you missed one thing: I am 85 now and probably could not wait to see any payoﬀ if we take B.”

2. Father: “I just got the membership at my favorite golf club and am set to enjoy. I am not prepared to give that all up.”

3. Son: “I have talked to my buddy, who is a reputable analyst of the industry. He says that although your forecast about B is in agreement with the market consensus, the market is over heated about this line of business and in his view B is a loser.”

What would you say to them?

Fall 2006 c J. Wang 15.401 Lecture Notes 1-16 Introduction to Finance Chapter 1

The Case for Value Maximization:

1. Shareholders’ ﬁnancial objectives:

(a) Increase of total wealth

(b) Right allocation of wealth over time

2. Shareholders can do (b) and (c) on their own, through ﬁnancial markets.

3. Financial manager can help only with (a), by increasing ﬁrm’s market value (i.e., shareholders’ total wealth).

15.401 Lecture Notes c J. Wang Fall 2006 Chapter 1 Introduction to Finance 1-17

Conclusions:

1. Managers should maximize ﬁrm’s current market value.

2. Shareholder diﬀerences can be settled in ﬁnancial markets by trading on their own account.

3. Perfect ﬁnancial markets allow separation of ownership and management.

Practical Issues:

• Agency problems - Management may put their own interest ﬁrst.

• Other stakeholders - Diﬀerent stakeholders may have conﬂicting interests.

• Imperfections in ﬁnancial markets.

Fall 2006 c J. Wang 15.401 Lecture Notes 1-18 Introduction to Finance Chapter 1 5 Summary

Key Points:

1. Objective of managers: maximize ﬁrm’s current market value.

2. Evaluating a business boils down to valuation of its assets.

3. An asset is deﬁned by its cash ﬂow (CF).

4. Two important characteristics of CF: timing and risk.

5. Value of assets (CFs) are determined by ﬁnancial markets.

6. Cost of capital: Expected return on equivalent investments in ﬁnancial markets.

7. Present value: Value of a CF is its expected value discounted at the opportunity cost of capital, which adjusts for both time and risk.

Key Assumptions:

1. “Perfect” ﬁnancial markets.

2. No agency problems and conﬂicts among stackholders.

15.401 Lecture Notes c J. Wang Fall 2006 Chapter 1 Introduction to Finance 1-19 6 Homework

Readings:

• BKM, Chapters 1, 2, 3.

• BMA, Chapters 1, 2.

Fall 2006 c J. Wang 15.401 Lecture Notes